A Summary of the Updated Regulations for Qualified Opportunity Zone Investments

It has been very well publicized that the Tax Cuts and Jobs Act enacted a new opportunity to incentivize real estate investment and development in low-income communities across the country. In October of 2018, the IRS published proposed regulations on this program that provided direction to taxpayers, although many questions were left unanswered.

In April of 2019, the IRS sought to address many of those questions by publishing a second set of proposed regulations which provided needed clarity on conducting an operating business within a Qualified Opportunity Zone and structuring a Qualified Opportunity Fund.

Within this article, we will summarize the recently-issued proposed regulations, structuring a QO Fund and other items to consider.

Let’s Start with the Background of Qualified Opportunity Zones

Qualified Opportunity Zones (“QO Zones”) are a community development tool benefitting low-income areas by bringing significant financial incentives for real estate developers who invest in economically distressed communities. This new incentive is designed to draw long-term investments to low-income communities across the nation that may not have seen such efforts any other way.

QO Zones allow investors who previously recognized a taxable gain to defer it by investing the gain proceeds into a Qualified Opportunity Fund (“QO Fund”). QO Zones are designated low-income housing tracts in the United States (and U.S. Territories i.e. Puerto Rico) in which a population census tract is above the poverty rate, or the median family income does not exceed a percentage of the statewide median family income.

The investor interested in benefitting from this newly created program must invest their capital gain from a previous transaction into a QO Fund. Please note that this can be any gain from the sale of real or non-real property. The gain is deferred by investing the amount of the gain into a QO Fund, hence the return of the capital portion does not need to be invested to benefit from the deferral. Generally, the investment must be made within 180 days after the sale of the property which triggered the gain (referred as the “180-day rollover-investment-period”). The gain is deferred to the earlier of (i) the date on which a QO Fund is disposed or (ii) December 31, 2026. The deferred gain retains its tax attributes at the time of the sale, so if the gain being deferred is short term capital gain, the gain will continue to be short term capital gain.

Basis increase of a QO Fund.

An investor’s initial tax basis of a QO Fund is initially zero since the cash being invested is from a transaction in which the gain is being deferred. However, if the investor holds its interest in a QO Fund for at least five years, the tax basis is increased by 10% of the deferred gain; if the interest is held for at least seven years, the basis of the deferred gain is increased by an additional 5% of the original gain. Hence there is a potential of an overall basis step-up of 15% on the deferred gain.

Elimination of the gain on certain properties held by a QO Fund.

Investors that hold the QO Fund investment for at least 10 years can receive the added benefit of paying no tax on any realized appreciation in investments made with the QO Fund. Please note that this permanent exclusion would only be beneficial for any gain appreciation after December 31, 2026 since the original gain which was invested in the QO Fund will need to be recognized.

QO Funds and the Certification Process:

An eligible taxpayer self-certifies as a QO Fund by filing Federal Form 8996 with its Federal income tax return. There is no other approval or action by the IRS required. Form 8996 must be filed timely, extension included. Eligible entities include (but not limited to) Partnerships (GP, LP, LLCs) and corporations. An individual, trust, estate or single-member LLC cannot be a QO Fund.

QO Fund Asset Testing Requirements

QO Fund must invest at least 90% of its assets in a QOZ business property to benefit from this initiative. OZ rules require that the QO Fund performs an Asset Test every six months to determine that at least 90% of its assets are invested in a QZ. If the QO Fund has less than 90% invested in the OZ, the QO Fund must pay a nondeductible penalty every month it fails to meet the 90% threshold.

The default rule to determine balance sheet values is based on the “applicable financial statement” of such entity (i.e., if QO Fund files a GAAP audited financial statement then the 90% asset test using GAAP values must be performed). If a QO Fund does not have an applicable financial statement, the cost basis of assets is used for the test.

What Can a QO Fund Invest In?

A QO Fund can invest in any of the following Qualified Opportunity Zone Businesses (“QO Zone Business”):

QO Zone Business Property is tangible business property held in a QO Fund.

QO Zone Stock where a QO Fund holds a corporate interest in a corporation that invests in a business located in a QO Zone.

QO Zone Partnership Interest where the QO Fund holds a partnership interest in which such partnership invests in a business located in a QO Zone.

The investment must be an equity investment to benefit from the QO Zone initiatives, therefore investment cannot be structured as a loan. An interest in a QO Fund that is issued for services (i.e., a carried interest) is not eligible for the tax benefits under the QO Fund regime.

What is a QO Zone Business Property?

A QO Zone business property must be an investment acquired by cash after December 31, 2017 and must be tangible property used in a trade or business acquired by purchase after 2017 from an unrelated party.

It is important to note that the original use of the acquired property must start with the QO Fund, or the QO Fund must substantially improve the used property. The substantial improvement requirement is met if 30 months after the date of acquisition the additional improvements to the property exceeds the cost of acquiring the property. You should only count the cost of building and improvements, not land. The QO Fund does not have to acquire new property, but the property cannot have been used before in a QO Zone.

Related Party Rules:

Capital gains from a sale or exchange with a related person is not eligible for deferral under the QO Zone initiatives.

A taxpayer would be unable to acquire any real estate in which it previously owned greater than a 20% ownership interest directly or indirectly through family attribution in such property.

Through common ownership of two related entities (i.e., partnership or corporation) and such persons own more than 20% in value of the outstanding stock of such corporation(s), and/or more than 20% of the capital interests, or the profits interests, in the partnership(s).

In a one-tier structure, a QO Fund would hold the real property or operating business in the QO Zone directly. In a two-tier structure, the QO Fund would hold an ownership interest in a partnership or QO Zone Corporation. The lower-tier entity would be the entity operating in the QO Zone. The QO Fund receives the deferred capital gain cash proceeds and elects to be treated as a QO Fund once it receives those proceeds.

The QO Fund can be a newly created partnership (or an existing partnership) which would invest the cash proceeds in the lower-tier operating company, referred to here on out as “OpCo”. OpCo can be taxed as either a partnership or Corporate entity. OpCo would directly invest in an eligible QO Zone Business. The QO Fund would contribute the cash to OpCo in exchange for an ownership interest and would need to own at least 90% interest in OpCo. Both entities would need to create separate bank accounts.

Here are the two primary benefits of a two-tier structure:

Only 70% of the assets held by OpCo must be held in a QO Zone, meaning 30% can be located outside of the zone. With a single-tier structure in comparison, 90% of the assets would need to be invested in a QO Zone.

Working Capital Safe Harbor (WC Safe Harbor): The QO Fund will have 31 months, starting when the cash is contributed to the QO Fund, to treat the deferred-gain-cash as a qualifying asset for purposes of the 90% asset test. Effectively, the WC Safe Harbor suspends the asset test since the QO Fund would fail as it would only hold partnership in a lower-tier investment and the lower-tier partnership only holds cash during the period the QO Fund is planning to acquire a QOZ Business Property.

WC Safe Harbor has three primary requirements to be respected:

The QO Zone partnership must have a written plan to spend the deferred-gain-funds received from the QO Fund for the acquisition, construction, and/or substantial improvement of tangible property located in a QO Zone.

The QO Zone partnership must have a written schedule timeline to acquire the real property, make necessary improvements, and have the property placed in service within 31 months.

The QO Zone partnership’s working capital assets are used in a manner that is substantially consistent with its written plan and timeline. It cannot hold the cash in checking account idle.

From a practical standpoint, WC Safe Harbor works best if the QO Fund has an executed non-binding letter of intent to acquire properties located in a QO Zone. This will show a good-faith effort that the QO Fund has spent resources and incurred due diligence costs for projects in the QO Zone in which the QO Zone partnership will deploy its capital.

The 31-month period can be extended for delays attributable to waiting for government action which had been applied within the 31-month period. Overlapping or sequential applications of safe harbor permitted (e.g., upon subsequent rounds of equity financing) provided that each infusion of working capital independently meets requirements of the WC Safe Harbor, even if it takes more than 31 months on a cumulative basis to spend the aggregate amount of working capital.

Note: Both sets of proposed QO Zone regulations issued by the Treasury do not provide a formal procedure in terms of the layout of the written plan. We are still awaiting this guidance.

Investment period for Capital Gains passed through a partnership interest:

The initial set of proposed regulations created additional flexibility in terms of the time frame to invest capital gains reported from a flow through K-1. A partner's eligible capital gains included in the partner's distributive share (and reported on its K-1) generally begins on the last day of the partnership tax year in which the partner's allocable share of the partnership's eligible gain is considered. There is additional flexibility in which the partnership itself may rollover the capital gains to the QO Fund.

However, a partner may elect to treat its 180-day rollover-investment-period as being the same 180-day period that would apply to the time the asset is sold.

Here is an example to illustrate:

Five individuals own identical ownership interests in a calendar year Partnership, referred to as Gain LLC. On January 17, 2019, Gain LLC realizes capital gain of $1,000,000 that it decides not to elect to defer by investing in a QO Fund. The 180-day rollover-investment-period starts at the partnership’s year end (i.e. December 31, 2019) and ends on June 28, 2020. Two of the partners want to defer their allocable portions of the capital gain. One of these two partners invest $200,000 in a QO Fund during February 2019. Under the general rule, this investment is made within the 180-day period for that partner. The other partner decided to defer their share of capital gains in a QO Fund on February 2019. Under this elective rule, the 180-day-investment-period began on January 17, 2019 and ended on July 15, 2019.

Additional items added by the second set of proposed regulations issued on April 17, 2019:

Timeframe for assets to be invested:

Section 1231 gains (taxed as capital gain rates) are required to be netted with Section 1231 losses to determine the amount, if any, of Sec. 1231 capital gains a taxpayer has available to invest. As such, Sec. 1231 gain is only determinable as of the last day of the taxable year of the taxpayer. For individual taxpayers with Sec. 1231 gains generated during 2019, the 180-day-rollover-investment period starts December 31, 2019 and ends on June 28, 2020.

Note: the last day that the 15% basis step-up for investments made to QO Funds will be December 31, 2019. After this date, investors will be eligible to receive basis step-up of 10%.

Clarification of “substantially all” requirements in various items:

The proposed regulations expand on the “substantially all” requirement in the following items:

“Substantially all” threshold is 90% when used to measure a QO Fund’s holding period of tangible property as qualified OZ business property, QOZ partnership or corporation, and

“Substantially all” threshold is 70% of the property’s use must be in an QOZ, and 70% or more of the property owned or leased by a QO Zone Business must meet the definition of a QO Zone Business.

What happens if a QOF investor dies during the investment period?

Upon the death of an investor, the investment will be passed on. The heirs of the investor will now receive the benefits from the original QOF investment, including the tax carryover basis of such investment. As a result of death of the investor, the holding period of the investment does not restart for the QO Fund investment purposes, i.e. the 5- and 7-year basis step-ups or the 10-year permanent gain exclusion.

Related-Party Lease Arrangement:

A QO Fund could enter a 99-year ground lease with the land owner, and the QO Fund could build the building and operate the rental activities. However, there are several restrictions here:

Lease payments are based on “market rent lease”

The Lessee does not make any pre-payments to the lessor that exceeds 12 months

In terms of the 90% asset testing, the value of the leasehold improvements would be based on either the applicable financial statements (i.e., GAAP) or present value of each payment under the lease. A discount rate will be based on the applicable AFR rate.

The earlier mentioned substantial improvement requirement does not apply to this arrangement.

In terms of the 10-year permanent deferral, only the portion related to the leasehold improvement would be eligible. The land would not be eligible since the land is not being held by a QO Fund.

Real Property Straddling a QO Zone:

If a taxpayer already owns a property near a QO Zone and wishes to expand by acquiring adjacent property located in a QO Zone, the following conditions can apply:

The QO Fund could purchase the adjacent property as part of one development project.

The adjacent property would count for purposes of the QO Zone investment if it is greater than the property located outside the QO Zone (measured by square footage).

The property outside of the QO Zone is contiguous as part of the entire development project, and the entire project would be deemed to be a QO Zone Business Property.

Treatment of Operating Businesses in the Zone:

It's not just a real estate game anymore – operating businesses can qualify as long as it meets one of the following three safe harbors:

At least 50% of the hours the employees or contractors work are spent in performing services for the QO Zone Business occur within the QOZ,

A minimum 50% of all payments the QO Zone Business makes for services are performed within the QOZ by employees, independent contractors, and employees of the independent contractors, or

Facts and circumstances test in which:

the tangible property of the business is in a QOZ and,

the management or operational functions performed in the QOZ are necessary for the generation of at least 50% of gross income.

Reinvestment Rule

QO Funds will now have a 12-month reinvestment period to sell assets and reinvest the proceeds into another eligible opportunity zone investment.

Vacant Properties

Under the new regulations, a building or other structure that has been vacant prior to being purchased by a QO Fund will satisfy the original use requirement if it has not been used for at least 5 years;

No Triple Net Leases

Leases structured as triple net leases (leases in which the tenant is required to pay a portion, or all, of the taxes, insurance, and maintenance costs for a property) are ineligible investments for QO Zone purposes since the main benefit of a triple net leased property is the passivity it allows the landlord.

Debt Financed Distribution

The new rules issued in the proposed regulations facilitate debt finance distributions from a partnership that will not be treated as an income inclusion event to the extent that the partnership debt allocations are done correctly. However, if the debt financed distribution is recharacterized as a disguised sale arrangement, then this would trigger an income inclusion event.

Ability to Roll Up All QO Fund Interest in a Single Parent Partnership:

Generally, if an investor transfers his or her interest in a QO Fund, there will be an “inclusion event” and the investor will be required to recognize the Deferred Gain. However, under certain circumstances, the New Proposed Regulations allow an investor to transfer his or her QO Fund interest to another partnership (Parent Partnership) in a tax-deferred capital contribution under Section 721 without triggering Deferred Gain if the QO Fund remains alive. The Parent Partnership will own the interest in the QO Fund and the Parent Partnership will step into the investor’s shoes for purposes of reporting the Deferred Gain. The Parent Partnership is required to allocate and report the gain associated with the transferred interest to the contributing partner. In other words, there is no reduction in the amount of the remaining deferred gain, and that amount will be reported to the transferring partner by the Parent Partnership if there is a future inclusion event. This provision may be particularly useful to permit all the members of related QO Funds to contribute (roll up) their interests in multiple QO Funds to a single Parent Partnership, which would then be the owner of multiple subsidiary QO Funds.

Purchase of a QOF Partnership Interest:

An investor can defer its capital gains by purchasing a QOF partnership interest from a direct owner of the QOF; the investor could elect to defer gains in the amount equal to the purchase price of a QOF partnership interest.

Treatment of Carried Interest Gain:

Where a person receives an interest in a QO Fund in exchange for services rendered to the QO Fund or to an entity in which the QO Fund holds any direct or indirect equity interest. Effectively, the portion of such person’s QO Fund interest received in exchange for such services is not treated as a qualifying investment. Thus, profits or carried interest in a QOF that is acquired for such services are not eligible for QOZ benefits. Furthermore, a capital interest acquired in exchange for such services is also ineligible for QOZ benefits.

In Conclusion

Investing in a QO Fund can be truly beneficial to real estate developers who will see significant tax incentives, and real estate owners who can sell these properties and defer the capital gains.

The Real Estate advisors at Sax will be sure to keep release updates on relevant developments as they emerge. For any questions on Qualified Opportunity Zones or setting up a Qualified Opportunity Fund, reach out to an expert within Sax’s Real Estate Practice at (973) 472-6250 or visit www.saxllp.co

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